Albeit with some variations depending on the school of thought, there are four main generally accepted principles of Islamic finance which are; Prohibition of Riba (usury/interest), prohibition of Gharar (excessive risk/uncertainty), Asset backed finance & Profit and Loss Sharing (PLS).
We have already covered Riba (usury/interest) and it prohibition both in Islam and other religions in our previous articles. Today we shall focus on Gharar.
WHAT IS GHARAR
Gharar can be loosely translated as ”excessive risk” or “uncertainty”. The term risk, risqué in French and risco in Italian is derived from the Latin roots re=back and secare=cut, thus reflecting the potential for sailor to have his ship cut by hitting a rock. In other words, “risk” means “danger of loss”.
This is precisely the meaning of the Arabic term gharar. Kharafy defines gharar as “that which has a pleasant appearance and a hated essence.”
In business, Gharar is the sale of probable items whose existence or characteristics are not certain due to the risky nature which makes the trade similar to (Maysir) gambling which has been prohibited in Quran chapter 5 verses 90 and 91.
In addition, there are numerous teachings of the Prophet ﷺ forbidding gharar sale. Among them is a narration reported by Abu Hurayra where the Prophet ﷺ prohibited the pebble sale and the gharar sale..” e.g. the sale of fish in water/pond/sea, sale of birds in the sky, sale of milk in the Udder, sale of unborn calf in the mother’s womb, sale of semen and unfertilized eggs of camels, sale of unripen fruits on the trees, sale of a lost camel.
All the aforementioned examples involve the sale of an items which don’t exist at the time when the contract is being effected. The fish might never be caught, a lost camel could never be found, or the milk in the udder could be lesser or more than expected hence lead to disagreements.
In another narration, the Prophet ﷺ forbade the purchase of the unborn animal in its mother’s womb, the sale of the milk in the udder without measurement, the purchase of spoils of war prior to their distribution, the purchase of charities prior to their receipt, and the purchase of the catch of a diver..”
In the above case of purchasing the catch of a diver i.e. paying a diver for whatever he may catch on his next dive. This is full of ambiguity and might lead to disagreements thereafter due to uncertainty of what could be harnessed, it could be expensive than the given amount or vice versa. The person who is paying does not know what he/she is paying for.
Islamic law of contract puts emphasis on having very specific details about what is being sold/bought and for what price. That is in the best interest of both the seller and the buyer.
Gharar can be eliminated by clearly stating the object of sale, quantified/valued and by fixing the price of sale in order to avoid ambiguities which may lead to disagreements. Disagreement and dispute go against the general objective of shariah.
In the case of the diver above gharar can for instance be removed by hiring the diver for a fixed period of time e.g. 12 hours. This is permitted because whatever the diver catches within the stipulated period belongs to the buyer and thus has no ambiguity. In this case the object of sale is the divers labour for 12 hours and is well defined.
GHARAR IN MODERN DAY TRANSACTION
In contemporary financial transactions, the two areas where gharar mainly affect are insurance and financial derivatives.
In insurance, premium are paid regularly to the insurance company, and the insured receives compensation for any insured losses in the event of a loss. Hence the insured may collect a large sum of money after paying only one monthly premium, on the other hand, the insured may also make many monthly payments without ever collecting any money from the insurance company. The insurance or security itself cannot be considered an object of sale.
It is on this basis that the conventional insurance has been rendered prohibited. The policy holder purchases a cover from an insurance company for an occurrence that is very risky and not certain. The covered risk (which is not an object of sale) e.g. fire, accident etc, may or may not occur hence Gharar (uncertainty) of the occurrence of the covered/stated calamity.
Derivative which among others comprise of forwards, futures and options are considered invalid because of gharar. In forwards and futures, the objects of sale may not exist at the time the trade is to be executed.
In cases where both the price and goods are to be delivered at a future date are considered invalid in Shari’ah. For example, I sell you this House for 5,000 USD at the end of next month or I sell you one of my cars in New York for 1,000 USD next year.
These transactions are invalid because they are not concluded hence ambiguities e.g. price and goods are both deferred and to be delivered at a future date. The date and specific type of car was not specified thus both the price and goods have been deferred in the contract hence gharar.
Islamic jurists have rendered the like of the aforementioned non-concluded sale as invalid since change of mind by one of the party in the agreement leads to disagreement.
Islamic Fiqhi scholars have agreed unanimously that a suspended conditional sale – bay ul mu’allaq is invalid because it consists of gharar e.g. I sell you my car for 1,000 Dollars if my wife returns from abroad.
In some cases however, Shari’ah has allowed or permits “gharar” in certain practises in order to meet peoples’ needs e.g. Salam and Istisna contracts are allowed to be used in order to meet people’s needs as we shall revisit them critically in our future articles on Islamic banking and finance instruments.